Ch. 19-Topic 4

1
Pearson Education 2011-Adapted by Dr. Fuad Kreishan
pp: 617-625
Economics,
Arab World Edition
R. Glenn Hubbard, Anthony Patrick OBrien,
Ashraf Eid, Amany El Anshasy,
Chapter 19
Output and Expenditure in the Short
Run
Pearson
PearsonEducation
Education2011
2011-Adapted by Dr. Fuad Kreishan
The Fluctuating Demand in the

Arab World: The Effects of the
Recent Global Financial Crisis
Learning Objectives
19.1 Understand how macroeconomic
equilibrium is determined in the
aggregate expenditure model.
19.2 Discuss the determinants of the
four components of aggregate
expenditure and define the
marginal propensity to consume
and the marginal propensity to
save.
19.3 Use a 45-line diagram to illustrate
macroeconomic equilibrium.
The greater openness and links to

the global economy increased
Arab countries exposure to global
downturns.
3
Pearson Education 2011
19.4 Define the multiplier effect and use

it to calculate changes in
equilibrium GDP.
19.5 Understand the relationship
between the aggregate demand
curve and aggregate expenditure.
APPENDIX Apply the algebra of
Chapter 19: Output and Expenditure in the Short Run
Output and Expenditure in the Short Run
Aggregate expenditure (AE)

The total amount of spending in the
economy: the sum of consumption,
planned investment, government
purchases, and net exports.
Learning Objective 19.1
The Aggregate Expenditure Model
Aggregate expenditure model

A macroeconomic model that focuses
on the relationship between total
spending and real GDP, assuming that
the price level is constant.
Aggregate Expenditure
Consumption (C)
Planned Investment (I)
Government Purchases (G)
Net Exports (NX)
Aggregate expenditure = Consumption + Planned investment +

Government purchases + Net exports
or:
AE = C + I + G + NX
The Difference between Planned Investment

and Actual Investment
Inventories Goods that

have been produced but not
yet sold.
Macroeconomic Equilibrium: Occurs where total spending,

or AE equals total production, or GDP
Aggregate expenditure = GDP
In the short run, we assume that the economy is not growing

then the equilibrium GDP will not change unless AE
changes.

Adjustments to Macroeconomic Equilibrium
Table 19-1
The Relationship between

Aggregate Expenditure and GDP
IF
THEN
AND
Aggregate expenditure is
equal to GDP
inventories are
unchanged
the economy is in
inventories rise
GDP and employment

decrease.
inventories fall
GDP and employment

increase.
Aggregate expenditure is
less than GDP
Aggregate Expenditure is
greater than GDP
So an increase or decreases in AE cause changes in GDP, thus to

be able to understand macroeconomic equilibrium, it is important to
understand what are the factors that determining AE?
Determining the Level of Aggregate

Expenditure in the Economy
AE = C + I + G + NX
TABLE 19-2
Components of
Real Aggregate
Expenditure, 2007
Source: WDI 2010, World Bank.

Consumption
10
FIGURE 19-1
Kuwaits Real
Consumption,
19702008
Consumption
follows an
upward trend,
interrupted
only infrequently
by recessions.
Source: Country National Accounts, United Nations, 2009.


1. Consumption
11
The following are the five most important variables that

determine the level of consumption:
Current disposable income
Household wealth
Expected future income
The price level
The interest rate

Consumption:
Current Disposable Income
12
The most important determinant of consumption is the current

disposable income of households.
disposable income: the income remaining to households after
they have paid income tax and received government transfer
payments.
Household Wealth
Consumption also depends on the wealth of households.
A households wealth is the value of its assets( home, stock,
bond& bank accounts) minus the value of its liabilities (loans
that it owes).

Consumption:
13
Expected Future Income
Consumption also depends on expected future income.

Most people prefer to keep their consumption fairly stable
from year to year, even if their income fluctuates
significantly.
The Price Level
The price level measures the average prices of goods and

services in the economy. Consumption is affected by
changes in the price level.
The Interest Rate
When the interest rate is high, the reward to saving is increased,

and households are likely to save more and spend less.

Consumption
14
The Consumption Function
Consumption function : The relationship

between consumption spending and
disposable income.
C= f (YD)
Marginal propensity to consume (MPC) The slope

of the consumption function: The amount by which
consumption spending changes when disposable
income changes.
MPC
Changeinconsumption
C
Changeindisposableincome YD

The Consumption Function
15
We can also use the MPC to determine how

much consumption will change as income
changes:
Changeinconsumption
MPC
Changeindisposableincome
or
Change in consumption = Change in disposable income MPC
Example: between 2013 and 2014, consumption increased by
$30 billion, while YD increased by $33 billion. Find MPC?
MPC = C/ YD = 30/33 = 0.90

The Relationship between Consumption and National Income
16
Disposable income = National income Net taxes

We can rearrange the equation like this:
National income = GDP = Disposable income + Net taxes

The Relationship between Consumption and National Income
17
FIGURE 19-2
The Relationship between
Consumption and National
Income

Income, Consumption, and Saving
18
National income = Consumption + Saving + Taxes

Change in national income = Change in consumption + Change in saving +
Change in taxes
Y=C+S+T
and
Y C S T
To simplify, we can assume that taxes are always a constant
amount, in which case T = 0, so the following is also true:
Y = C + S

Income, Consumption, and Saving
19
Marginal propensity to save (MPS)

The change in saving divided by the
change in disposable income.
or,
Y C S
Y Y Y
1 = MPC + MPS
Solved Problem
19-2
Calculating the Marginal Propensity to

Consume and the Marginal Propensity to Save
20
MPC
C
Y
MPS
S
Y
NATIONAL INCOME
AND REAL GDP (Y)
CONSUMPTION
(C)
SAVING
(S)
MARGINAL PROPENSITY TO
CONSUME (MPC)
MARGINAL PROPENSITY
TO SAVE (MPS)
$9,000
$8,000
$1,000
10,000
8,600
1,400
0.6
0.4
11,000
9,200
1,800
0.6
0.4
12,000
9,800
2,200
0.6
0.4
13,000
10,400
2,600
0.6
0.4

2. Planned Investment
21
FIGURE 19-3
Real Investment
Spending In
Egypt, 19702008
Investment is
subject to more
changes than is
consumption.
Investment declined
significantly in the
1980s but started
recovering during
the 1990s.

Planned Investment
22
The four most important variables that determine

the level of investment are:
Expectations of future profitability
The interest rate
Taxes
Cash flow

Planned Investment
23
Expectations of Future Profitability
The optimism or pessimism of firms is an important

determinant of investment spending.
The Interest Rate
A higher real interest rate results in less investment

spending, and a lower real interest rate results in more
investment spending.

Planned Investment
24
Taxes
Firms focus on the profits that remain after they have

paid taxes.
Cash Flow
Cash flow The difference between the cash

revenues received by a firm and the cash spending
by the firm.
Making
the
Connection
25
The construction
boom in the
GCC between
2004 and 2008
led to a huge
expansion in
steel production
capacity in these
countries.
The Construction Boom in the Gulf (20052008) Induces Steel Production Capacity
Growth

3. Government Purchases
FIGURE 19-4
26
Saudi Arabia Real

Government
Purchases, 19702008
Government spending
increased sharply after the
first oil price shock in
1974, and kept growing
but at a slower pace in the
1980s. At the beginning of
the 1990s, concerns about
the budget deficit caused
real government
purchases to fall for the
following four years,
beginning in 1991, before
it started steadily rising in
1996.

4. Net Exports
FIGURE 19-5
27
Jordans Real Net

Exports, 19702008
Net exports were

negative in all
years between
1970 and 2008.
Source: Country National Accounts, United Nations, 2009


Net Exports
28
The following are the three most important variables that

determine the level of net exports:
1. A countrys domestic price level relative to the price levels
in other countries.
2.The growth rate of GDP in the domestic economy relative
to the growth rates of GDP in other countries.
3.The exchange rate between a countrys currency and
other currencies.

Net Exports
29
1. A countrys domestic price level relative to the price levels

in other countries.
If inflation in the A is lower than inflation in other countries, prices of the A
products increase more slowly than the prices of products of other
countries and thus A export increases & its imports decrease,
2.The growth rate of GDP in the domestic economy

relative to the growth rates of GDP in other countries.
When incomes in the country A rise faster than incomes in other
countries, imports for A will increases and exports will decrease.
3.The exchange rate between a countrys currency and other

currencies.
An increase in the value of the countrys currency will reduce its
exports and reduce imports, so net exports will rise.
Graphing Macroeconomic Equilibrium

FIGURE 19-6
45-Line
Diagram,
Keynesian cross
30
Equilibrium
AE = GDP

FIGURE 19-7
The Relationship
between Planned
and GDP on a 45-Line
Diagram
31

FIGURE 19-8
Macroeconomic
Equilibrium on the 45-Line
Diagram
32
To draw AE graph
remember :
AE = C + I + G + NX
Graphically:
33
Equilibrium occurs at the

point at which the
aggregate expenditure
curve crosses the 45
line in part (a).
Equilibrium occurs when
there are no unplanned
changes in business
inventories in part (b).
34
If AE real GDP (the AE

curve is above the 45 line),
there is an unplanned
decrease in inventories,
To restore inventories, firms
hire workers and increase
production.
Real GDP increases.

If AE < real GDP (the AE
curve is below the 45
line),
there is an unplanned
increase in inventories.
To reduce inventories,
firms fire workers and
decrease production.
Real GDP decreases.

Showing a Recession on the 45-Line Diagram
FIGURE 19-10
Showing a Recession
on the 45-Line Diagram
When AE intersects the
the 45-Line at a level of
GDP below the potential
RGDP, the economy is in
Recession.
Recession: it is an
economic situation
where the economy will
operate below normal
capacity, unemployment
rate well be above
natural rate of
unemployment
The Important Role of Inventories
37
Whenever planned aggregate expenditure

is less than real GDP, some firms will
experience an unplanned increase in
inventories.
Making
the
Connection
38
Business Attempts to Control

Inventories, Then . . . and Now
Dell Computer uses supply chain

management to keep its inventory low.
A Numerical Example of Macroeconomic Equilibrium
39
Table 19-3
Macroeconomic Equilibrium
Real GDP
(Y)
Consumption
(C)
Planned
Investment
(I)
Government
Purchases
(G)
Net
Exports
(NX)
Planned
Aggregate
Expenditure
(AE)
Unplanned
Change in
Inventories
Real GDP
Will
$8,000
$6,200
$1,500
$1,500
$500
$8,700
$700
increase
9,000
6,850
1,500
1,500
500
9,350
350
increase
be in
equilibrium
10,000
7,500
1,500
1,500
500
10,000
11,000
8,150
1,500
1,500
500
10,650
+350
decrease
12,000
8,800
1,500
1,500
500
11,300
+700
decrease
Solved Problem
19-3
Determining Macroeconomic Equilibrium
40
Planned aggregate expenditure (AE) = Consumption (C) +

Planned investment (I) + Government (G) + Net exports (NX)
Unplanned change in inventories = Real GDP (Y)
Planned aggregate expenditure (AE)
Real GDP
(Y)
Consumption
(C)
Planned
Investment
(I)
Government
Purchases
(G)
Net
Exports
(NX)
Planned
Aggregate
Expenditure
(AE)
Unplanned
Change in
Inventories
$8,000
$6,200
$1,675
$1,675
$500
$9,050
$1,050
9,000
6,850
1,675
1,675
500
9,700
700
10,000
7,500
1,675
1,675
500
10,350
350
11,000
8,150
1,675
1,675
500
11,000
12,000
8,800
1,675
1,675
500
11,650
350
The Multiplier Effect

FIGURE 19-11
41
The economy begins

at point A, at which
equilibrium RGDP is
$ 9.6 billion, If there
is an increases in
investment by 100
million, AE1 shaft to
AE2 and the new
equilibrium is at B.
So 100 million
increase in
investment results in
$400 million increase
in equilibrium RGDP,
this is the Multiplier
effects.
Factors that will have Multiplied effect:
42
Autonomous expenditure An
expenditure that does not depend on
the level of GDP.
Multiplier The increase in equilibrium
real GDP divided by the increase in
autonomous expenditure.
Multiplier
Change in equilibrium real GDP

1
Change in autonomous expenditure 1 MPC
Multiplier effect The process by

which an increase in autonomous
expenditure leads to a larger increase
in real GDP.

Table 19-4
The Multiplier Effect in Action
43
Making
the
Connection
44
The Multiplier in Reverse:

The Great Depression of the 1930s
A Formula for the Multiplier
45
1
1 MPC
Multiplier
Change in equilibrium real GDP

1
Change in autonomous expenditure 1 MPC

Multiplier
400
4
100
With a multiplier of 4, each increase in autonomous expenditure

of $ 1 will result in an increase in equilibrium GDP by $ 4.
Summarizing the Multiplier Effect
46
1 The multiplier effect occurs both when autonomous

expenditure increases and when it decreases.
2 The multiplier effect makes the economy more sensitive
to changes in autonomous expenditure than it would
otherwise be.
3 The larger the MPC, the larger the value of the multiplier.
4 The formula for the multiplier, 1/(1 MPC), is oversimplified
because it ignores some real-world complications, such as
the effect that an increasing GDP can have on imports,
inflation, and interest rates.
Solved Problem
19-4
Using the Multiplier Formula
47
REAL GDP
(Y)
CONSUMPTION
(C)
PLANNED
INVESTMENT
(I)
GOVERNMENT
PURCHASES
(G)
$8,000
$6,900
$1,000
$1,000
$500
9,000
7,700
1,000
1,000
500
10,000
8,500
1,000
1,000
500
11,000
9,300
1,000
1,000
500
12,000
10,100
1,000
1,000
500
a. What is the equilibrium level of RGDP?

b. What is the MPC?
c.
NET EXPORTS
(NX)
Suppose G increase by $200billion. What will be the

new equilibrium level of RGDP?
Solved Problem
19-4
Using the Multiplier Formula (continued)
48
REALGD
P
CONSUMPTION
(Y)
(C)
PLANNED
INVESTMENT
(I)
GOVERNMENT
PURCHASES
(G)
NET
EXPORTS
(NX)
PLANNED
AGGREGATE
EXPENDITURE
(AE)
$8,000
$6,900
$1,000
$1,000
$500
$8,400
9,000
7,700
1,000
1,000
500
9,200
10,000
8,500
1,000
1,000
500
10,000
11,000
9,300
1,000
1,000
500
10,800
12,000
10,100
1,000
1,000
500
11,600
a. the equilibrium level of RGDP = $10.000

b. the MPC = C/ Y = 800/1000 = 0.8
c.
M = 1/1-MPC = 1/ 1- 0.8 = 5
So Y = M * exp = 5 * 200 = 1000 billion, thus the new

level of equilibrium GDP = 10000+ 1000 = 11000
billion
The Aggregate Demand Curve

FIGURE 19-12
The Effect of a Change in

the Price Level on Real GDP
49

FIGURE 19-13
50
A curve that shows the

relationship between the price
level and the level of planned
aggregate expenditure in the
economy, holding constant all
other factors that affect
aggregate expenditure.
An Inside LOOK
51
Jordan Expected Thousands of Workers Home

from the Gulf: Is it Good News for the Jordanian
Economy?
Can Jordan Dodge the Downturn Bullet?
Key Terms
52
Aggregate demand curve

Aggregate expenditure (AE)
Aggregate expenditure model
Autonomous expenditure
Cash flow
Consumption function
Inventories
Marginal propensity to
consume (MPC)
Marginal propensity to
save (MPS)
Multiplier
Multiplier effect
Appendix
The Algebra of Macroeconomic Equilibrium
53
1 C C MPC (Y ) Consumption function

2 I 1
Planned investment function
3 G G
Government spending function
4 NX N X
Net export function
Y C I G NX
Equilibrium condition
Appendix
54
The letters with bars over them represent fixed, or autonomous,

values. So, C represents autonomous consumption, which had a value
of 1,000 in our original example. Now, solving for equilibrium, we get:
Y C MPC(Y) I G NX
Or,
Y - MPC(Y) C I G NX
Or,
Y (1 MPC ) C I G NX
Or,
C I G NX
Y
1 MPC
Appendix
55
1
is the multiplier. Therefore an alternative
1 MPC
expression for equilibrium GDP is:
Remember that
Equilibrium GDP = Autonomous expenditure x Multiplier

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1

Pearson Education 2011-Adapted by Dr. Fuad Kreishan

The Fluctuating Demand in the

The greater openness and links to

Pearson Education 2011

19.4 Define the multiplier effect and use

Chapter 19: Output and Expenditure in the Short Run

Output and Expenditure in the Short Run

Aggregate expenditure (AE)

Pearson Education 2011

Learning Objective 19.1

Chapter 19: Output and Expenditure in the Short Run

The Aggregate Expenditure Model

Aggregate expenditure model

Pearson Education 2011

Learning Objective 19.1

The Aggregate Expenditure Model

Chapter 19: Output and Expenditure in the Short Run

Aggregate expenditure = Consumption + Planned investment +

Pearson Education 2011

Learning Objective 19.1

The Aggregate Expenditure Model

Chapter 19: Output and Expenditure in the Short Run

The Difference between Planned Investment

Inventories Goods that

Macroeconomic Equilibrium: Occurs where total spending,

In the short run, we assume that the economy is not growing

Pearson Education 2011

Learning Objective 19.1

The Aggregate Expenditure Model

Chapter 19: Output and Expenditure in the Short Run

The Relationship between

GDP and employment

GDP and employment

So an increase or decreases in AE cause changes in GDP, thus to

Pearson Education 2011

Learning Objective 19.2

Determining the Level of Aggregate

Chapter 19: Output and Expenditure in the Short Run

Source: WDI 2010, World Bank.

Pearson Education 2011

Learning Objective 19.2

Determining the Level of Aggregate

Chapter 19: Output and Expenditure in the Short Run

Source: Country National Accounts, United Nations, 2009.

Learning Objective 19.2

Determining the Level of Aggregate

Chapter 19: Output and Expenditure in the Short Run

The following are the five most important variables that

Current disposable income

Expected future income

The price level

The interest rate

Pearson Education 2011

Determining the Level of Aggregate

Learning Objective 19.2

Current Disposable Income

The most important determinant of consumption is the current

Learning Objective 19.2

Determining the Level of Aggregate

Chapter 19: Output and Expenditure in the Short Run

Expected Future Income

Consumption also depends on expected future income.